Sunday, November 23, 2014

Europe’s Top-Down Myopia

MUNICH – The French statesman Georges Clemenceau famously remarked that, “Generals always fight the last war.” Today, in the wake of the euro crisis, the same might be said of the European Union as it seeks to put itself on a more stable institutional footing.

The EU is undergoing fundamental changes, many of which have gone largely unnoticed, owing to the overwhelming focus on large-scale top-down reforms. Officials seem not to recognize change unless it takes the form of Eurobonds, new European treaties, or policy reversals by German Chancellor Angela Merkel. But the case for small steps guided by market mechanisms is strong.

Europe’s obsession with top-down reforms is rooted in prevailing analyses of the causes of the euro crisis. Most people in Germany, the Netherlands, and Finland blame excessive public spending and inadequate regulation in countries like Greece, Spain, and Cyprus for destabilizing the eurozone and, in turn, the EU.

A somewhat more nuanced analysis holds that the euro itself is responsible for these countries’ problematic spending. The European Central Bank’s one-size-fits-all monetary policy created destabilizing imbalances in the eurozone. Interest rates were too low in Southern Europe, where governments and households binged on cheap loans, and arguably too high in Germany, which was already held back by the economic burden of reunification.

If the euro generated these imbalances, the argument goes, country-level solutions are inadequate. Europe’s only option is to repair and strengthen the currency union through banking, fiscal, and political union.

A banking union really is needed to break the vicious cycle of weak banks and debt-laden governments. The good news is that its contours are fairly clear, and the process of constructing it is already underway, though the pace is very slow.

But the logic behind fiscal union is muddier – not least because its proponents have largely failed to explain exactly what it means. The implication is that it would entail a much larger EU budget, presumably financed by some kind of EU-wide taxation, as well as eurozone-backed unemployment insurance and a debt-mutualization mechanism like Eurobonds.

The centralization of financial and fiscal powers would demand increased accountability at the European level. For that, a political union – with directly elected European officials and a significantly more powerful European Parliament – would be needed.

This is unlikely to happen, at least in the foreseeable future. But that probably does not matter as much as many people claim.

The fact is that in designing elaborate new institutions in response to the events of the last five years, there is a risk of fighting a rearguard action, rather than looking ahead to meet new challenges. After all, the eurozone crisis was rooted in the emergence of imbalances generated by the euro’s introduction and, to a lesser extent, German reunification. But neither event will happen again.

Moreover, the imbalances generated during the euro’s first decade are already being resolved. Indeed, the painful adjustments that southern European countries (and Ireland) have endured have led to substantially smaller external deficits and declining unit labor costs. Nowadays, Spain’s exports are growing faster than Germany’s. The changes that countries like Spain and Portugal are making to their labor laws, pension schemes, and regulatory systems are encouraging. These improvements will put increasing pressure on France and Italy to follow suit, which could make Europe as a whole more competitive.

Furthermore, the politics of the eurozone currently are not conducive to lasting reforms. The crisis has amplified the role of Germany – with its economic size and large external surplus – and made everyone else look weak. If Europe were to thrash out a fiscal and political union now, it would look too rigidly rules-based, too Germanic. As the rest of Europe recovers (and as Germany squanders some of its economic power by going slow on domestic reforms), Germany’s relative strength will decline. An EU without one overly dominant power could probably establish more broadly acceptable – and thus more durable – institutions.

If past problems are already being corrected, and future problems will be of a different kind and magnitude, then perhaps there is no need for Eurobonds or EU taxes. And, without debt mutualization or large-scale redistribution of wealth, political union becomes unnecessary – at least for now.

This is not to say that European institutions did not need more authority than they had before the crisis. Even without fiscal and political union, the European Commission has been empowered to supervise fiscal spending and other macroeconomic developments – such as wage growth and real-estate prices – that could cause imbalances to re-emerge.

Likewise, the ECB, together with national bodies, has gained the authority to supervise major eurozone banks. But it is also critical to recognize that financial markets have become more disciplined.

Herein lies the discrepancy between those who put their faith in institutional fixes and those who trust a more bottom-up approach. Many people, especially in the United Kingdom and the United States, seem to believe that “solving” the euro crisis means returning to the Elysian state in which all European government bonds are equally risk-free assets. But, for Germans, Dutch, and Austrians, interest-rate spreads are not the problem; they are part of the solution, given that they impose discipline that extends beyond European institutions’ new powers.

The eurozone’s new institutional framework does not have to direct 18 countries’ fiscal and economic policies. It just needs to be strong enough to enable markets to recognize and react to worrying developments, while offering real help to countries that find themselves temporarily in trouble. This is not only doable; it is being done. Now European countries can turn to the challenge of becoming more flexible and productive so that they can be more competitive in the future.

This commentary reflects the author's personal views.

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    1. Portrait of Michael Heller

      CommentedMichael Heller

      Begad! On my profile page I am alleged to have said what Zsolt Hermann said, which I strenuously deny. Here is what I said:
      "Zsolt, having seen your copious spiritual comments for a year or two my eyes now glaze over and go round and round - and round - in a (no surprise) circular direction, much like your comments which - no disrespect - never seem to go forward to anywhere new. Am I being unfair to you?"

    2. CommentedWalter Gingery

      The significant thing about this post is, in my opinion, that it confirms the notion that the policy response to the Euro crisis has been completed. The Euro-police ("Jolly Olli" Rehn, Schaeuble, etc.) have closed down all the alternatives. So, no fiscal union, no exiting the Euro, no forgiving debt, no reflation from the ECB. From here on out, we'll just have to wait and see how the situation develops until the Euro Parliamentary elections in Spring.

    3. CommentedWilhelm Röpke

      Well, this is this well-known approach we can read throughout the analyses written by English-speaking people.

      In fact, the euro crisis is a false term. De facto, this crisis contains several parts which are linked together. The single currency is more or less to be understood as a catalyst.

      Some countries were allowed to borrow cheap money and piled debt sky-high. Banks have been allowed to leverage to an extend that is criminal. If their equity were at a ratio of 2 to 5% of their total assets, nobody should say this was sound and good. And this is still the core of all the problems the euro zone is facing. The big problems are the banks which are over-leveraged, ailing and IF "the experts" were precise and honest - are insolvent.

      In addition, the Southern countries have raised their wages to an extent which has not been backed by (their) productivity. Because of the better purchasing power, due to the euro, the people in the Southern countries have bought wares and services from abroad. That has led to the substitution of domestically produced wares and services.

      The euro zone has tumbled since the governments bailed-out the banks. In turn that has led to even more public debts and these debts have been financed by the taxpayers. However, the taxpayers were in trouble because the economy has been fading. The fading of the Southern economies is a result of too high wages, deindustrialisation, current account deficits.....

      What the euro does is to make a recovery, as those countries were used to, very hard since they are obliged to devalue internally and are thus obligated to reform their supply side objectives. All the problems are much more obvious than before the pre-euro time and hence harder to cure.

        CommentedWalter Gingery

        Well, this is the well-known Euro0phile analysis.

        A Eurosceptic would say that the Germans threw a monkey wrench into the Euro-works when they inaugurated the Schroeder reforms of the late '90's, which repressed domestic consumption and ramped up production with the aim of reducing German unemployment levels.

        What they didn't count on, and still don't understand, is how the excess savings and production have in the past destabilized the rest of the Eurozone and continue to do so. It is revealing that you use the word "allowed" to borrow. In fact, they had little choice, with Germans (and Finns, and the Dutch, etc.) flooding them with cheap money funded by excess savings, while at the same time Germans (and Finns, and the Dutch, etc.) repressed domestic consumption so they didn't supply a market to the "some countries." How can you sell your goods, if Germans, etc., aren't buying? Oh, now I understand: blame the victims: they are morally culpable, lazy, cunning, etc.

        In the present circumstances, the Spanish, Portuguese, Irish, Italians, and the French are pursuing the chimera of "competitiveness." It is my hunch that, no matter how thoroughly they modernize their labor markets, they will never achieve a level playing field with the Northern Euromembers. For once the Germans begin to experience the true effects of real competition -- falling sales and rising unemployment -- they will turn around and repress domestic consumption even more, and then the whole sorry cycle will begin again.

    4. Commentedhari naidu

      If one has learnt anything from Draghi/ECB, the global financial crisis was a crisis of sovereign governance and NOT, as you claim, a Euro crisis. And, if you’d worked in Brussels – instead of myopic London – you would perhaps understand the historical raison d’etre for official adoption of Euro (16 Dec’1995) and its introduction on 1 Jan’1999.

      For example, Maastricht Treaty (1992) which introduced the Euro could not introduce fiscal union because President Mitterrand opposed it. Bundesbank didn’t support introduction of Euro, but Chancellor Kohl forced their hands…. When final history of Euro is written these and other facts will become obvious.

      It will now depend on Chancellor Merkel if Banking Union (BU) will materialize as formally agreed upon by Council, EP and Commission, under ECB management. And, since a German lady will be in-charge of BU, it is possible the path to Euro stability and its macro governance will no longer depend on its sovereign’s. Monetary policy convergence will inevitably remove bottle-necks of sovereign interference with banks and their balance sheets.

      Euro is the second reserve currency of the world today - after USD.

      Suffice it to say, those who get lost in the forest sometimes don’t see the forest. They just see trees!

    5. CommentedKrzysztof Bledowski

      The “banking union” makes sense if the entity has a claim on unlimited fiscal resources to buy/resolve banks in trouble. Such a claim is only possible within a “fiscal union” which centrally manages a pool of resources. Yet a fiscal union must be answerable to a democratic mandate within the mantra of “no taxation without representation”. Hence, a “political union” is needed to support a fiscal union.
      As much as I sympathize with Katinka’s embrace of realism, I cannot subscribe to her mutually-exclusive analysis of these three “unions”. They all belong together or they don’t belong.

    6. Portrait of Michael Heller

      CommentedMichael Heller

      I just read something over at the WSJ that immediately reminded me of this article. It’s WSJ quoting Andrew Ferguson writing about the ideas of Sir John Cowperthwaite a British civil servant. None of the preceding words are relevant, just my duty to the sources, but I hope other readers may also appreciate joining these dots (if I'm right) --

      “Stripped of his numbers an economist would have to resort to the old home truths about how the world works: If you tax something you get less of it; as a general rule an individual manages his own affairs better than his neighbor can; it's rude to be bossy; the number of problems that resolve themselves if only you wait long enough is far larger than the number of problems solved by mucking around in them. And the cure is often worse than the disease: ‘In the long run, the aggregate of the decisions of individual businessmen, exercising individual judgment in a free economy, even if often mistaken, is likely to do less harm than the centralized decisions of a Government; and certainly the harm is likely to be counteracted faster.’ Somehow the most successful practical economist of the twentieth century knew this was true, and he didn’t have to work out a single equation.”

    7. CommentedZsolt Hermann

      I agree with the basic point, which is that the current system cannot be corrected or governed in a top down fashion any more.
      We evolved into a round, globally interconnected and interdependent system, where the previous pyramid like human structure has become obsolete.
      We have to develop a completely new, round, circular decision making system built on wide round table discussions at the initial stages, feeding into smaller, still circular, equal, transparent and "self-less", truly public servant committees making the final executive decisions, initiating action.
      And regarding Europe and the Euro, the whole concept is now falling apart since people tried put a ceiling over a house which did not have walls, or even a foundation.
      We cannot create a united financial structure, common market, single currency when at the base there is no integration, unity, moreover below the "unity" ruthless, exclusive competition exists.
      Such an arrangement is unheard of in any integral, natural, or even logical system arrangement, and has no possibility to exist in a sustainable manner, and even with constant tinkering, cheating and cosmetic surgery is doomed to failure.

        Portrait of Michael Heller

        CommentedMichael Heller

        Zsolt, having seen your copious spiritual comments for a year or two my eyes now glaze over and go round and round - and round - in a (no surprise) circular direction, much like your comments which - no disrespect - never seem to go forward to anywhere new. Am I being unfair to you?